updated 08:08 am EDT, Mon May 12, 2014

Apple's acquisition of Beats Electronics gives it what it needs right now

A lot of eyebrows were raised when rumors of Apple's purported acquisition of Beats Electronics surfaced over the past few days. Until now, Apple is a company that has been known for making relatively small, targeted, acquisitions that have often eventually found their way into shipping Apple-engineered products as technological enhancements giving it a competitive edge. With around $150 billion in cash and liquid assets, all eyes have been on Apple for some time, waiting to see what it might splash out some of that cash on. No one outside of Apple could see the acquisition of Beats Electronics coming, and certainly not for what seems a somewhat hefty $3.2 billion.

Many pundits and analysts have struggled to come to terms with why Apple might want to purchase Beats, particularly when set against its past acquisition history. After all, if Apple wanted to get into the premium headphone market, it could have easily done so itself. It already makes its own EarPods and in-ear headphones, and it certainly has the technical capability to develop its own premium headset design. It could have also purchased any number of, what many people consider, superior headphone companies instead of Beats. Sennheiser, Harman Kardon, and Bose spring to mind - like Beats headphones, Apple sells each of these brands (in some cases exclusively) in its Apple stores.

As a headphone brand, Beats has been exceptionally well marketed and has taken the lion's share of the premium headphone market with it. With around 70 percent of the premium headphone market captured, it stands as a stunning achievement by any measure. Its headphones retail for up to $399 and have very tidy gross margins, which could be as high 80-90 percent based on unit costs to manufacture. We have previously reviewed a set of Beats Solo HD headphones in comparison with Harman Kardon's CL Classic headphones and found that while they are nicely styled and well made, the Harman Kardon CL's produce a far superior listening experience that is much better balanced for the same money. The same could be said for the equivalent Sennheiser and Bose headphones, which are also technically superior. Despite this, young people love them to the point where the company is said to be generating around $1 billion a year in revenue.

Apple is already making cash hand-over-fist, so while the purchase of Beats Electronics will add to Apple's bottom line, it is not going to do so in any substantial way compared to its other hugely successful product lines like the iPhone and iPad. This leaves Beats' recently launched, and critically well-received Beats Music service as the likely target of Apple's interest. It is not the first time that Apple has shown an interest in purchasing music streaming services. In 2010, under the reign of the late Steve Jobs, Apple purchased the music streaming service Lala, which it promptly shuttered around one month after Apple's acquisition. Apple eventually rolled a number of Lala's streaming music features into the iTunes Store and then iTunes Match and iTunes Radio. However, Apple's music business (which has been instrumental in driving iPod and iPhone sales) is starting to wane with Apple's Pandora-like iTunes Radio failing to drive music sales.

After experiencing strong growth, digital music buyers have been shying away from buying music outright in favor of subscription services that allow you to both stream random songs as well as download individual tracks or entire albums for listening when offline. Up to 20 percent of digital music is now served up this way, a figure that is quickly growing. While Apple is more than capable of designing its own subscription music service equivalent, it would take considerable time and resources to develop a compelling streaming service. Further, despite Apple's reputation for industrial design and software UIs, iTunes Radio features a very basic interface design is not particularly engaging. The inability to download and listen to entire albums offline also disappointed a lot of music lovers. Beats Music on the other hand, is beautifully designed and has excellent algorithms that are particularly adept at tailoring music to a user's preferences. It also gives Apple what it could do with right now - a very well-designed streaming music service that is also properly curated. Its back-end personalization algorithms could also find their way into other Apple web services.

If Beats didn't also make headphones that can polarize people's opinions (or failed to drive HTC's smartphone sales) it seems unlikely that anyone would have had too much to complain about if Apple had simply acquired another music streaming service. That is, except for the price. $3.2 billion is a lot of money for a music streaming service that only has around 200,000 current subscribers. However, it is not quite so large a sum when you factor in the fact that Beats headphone sales over the next few years can be expected to quickly make the acquisition a cost-neutral, even cash flow positive purchase. I, like many others, will absolutely fall over if Apple decides to co-brand any of its products like HTC or HP with Beats logos. Given how much intrinsic brand value exists in Beats, I will be similarly surprised if Apple ditches the brand and simply absorbs Beats' products into the Apple portfolio as it has with other acquisitions.

It will be very interesting to see, if and when the acquisition is completed and announced, what is said about it, particularly by Apple CEO Tim Cook. As the largest single acquisition in Apple's history, it seems unlikely that Apple can keep a lid on its rationale. While it might not reveal all of its plans, one would expect that shareholders will be very keen to get inside Apple's thinking. Rest assured it must be very solid, as Apple's board would not sign off an acquisition of this scale without knowing the full story. With Apple 'on the prowl' for more acquisitions following a record year of purchases, it will be fascinating to see what Apple does next. Beats Music looks to be a strategic play for the music market in order to bolster Apple's existing business model. All eyes are on what Apple might acquire to branch out into new businesses, to help kick start renewed growth moving forward.